In a distributed exchange, the BTC private keys remain in your possession. MtGox is out of the picture, users are in control.
This is good in that there is no counterparty risk to using a distributed exchange. Bad because there’s no way to seamlessly place an order and pay for the order when it’s matched IF you’re using BTC. This is because you need to place the order, and then sign the BTC transaction with your BTC private key whenever the order is matched. This is the very nature of Bitcoin transactions, and there is no avoiding it!
With Counterparty assets, it only takes a single transaction to cover everything there is to decentralized trading. Counterparty assets make for faster, easier trades that support more functionality.
Here’s how Counterparty differs from normal BTC sends, ELI5 style, meaning it’s not totally accurate and is instead merely meant to be illustrative.
Imagine you send BTC to a special address in your wallet. The entire Bitcoin network KNOWS that, when you send BTC to this special address, you are really saying “I want to trade 0.5 LTBCOIN for 0.5 MPTSTOCK”. The entire network learns of your intentions as soon as you send even a tiny amount of BTC to this special address.
Your friend has a different special address of his own in his Bitcoin wallet. Imagine the Bitcoin network knows that when your friend sends a tiny amount of BTC to his special address, he is saying to the entire Bitcoin network: “I want to trade 0.5 MPTSTOCK for 0.5 LTBCOIN”.
Consequently, if YOU send 0.0000001 BTC to YOUR special address, and your friend sends 0.0000001 BTC to HIS special address, the network sees your orders match up. You want to sell 0.5 LTBCOIN for 0.5 MPTSTOCK. Your friend wants to sell 0.5 MPTSTOCK for 0.5 LTBCOIN. Great! The orders are matched by the Bitcoin network. Your 0.5 LTBCOIN is then automatically traded for your friend’s 0.5 MPTSTOCK.
MPTSTOCK and LTBCOIN balances were superimposed on top of the Bitcoin network, which is how the Bitcoin network knew you and your friend were both good for the money. After trading, the balances of LTBCOIN and MPTSTOCK are updated automatically.
The Counterparty protocol knows about balances due to the Proof of Burn period, which initialized the network with XCP, and XCP was then sacrificed to create MPTSTOCK and LTBCOIN. That’s how the network learns of those balances.
You might think of the Counterparty protocol as a more declarative and expressive form of Bitcoin transaction, because not only are you sending 0.000001 BTC to a special address, you’re declaring to the entire blockchain your intent to make a trade.
Getting slightly more technical, it works a little like this under the hood:
1) You place a buy order by embedding data into the blockchain of the form “CNTRPRTY: buy X, sell Y”; it’s self-contained, this is embedded consensus data to use buzzwords!
2) wait for the order to be matched, e.g. your friend places an order by embedding data into the blockchain of the form "CNTRPRTY: buy Y, sell X"
3) once matched, the orders are automatically executed and balances update.
In summary, you make declarative Bitcoin transactions to reveal your intent to trade to the global Bitcoin network. The Counterparty reference client can parse the full blockchain, looking for special addresses with this declarative data. When Counterparty’s reference client finds the declarative data, it parses it to 1) learn of open orders, 2) match matching orders and 3) automatically execute trades without waiting for disparate parties to sign transactions. It’s wholly efficient, decentralized and equally as secure as using the Bitcoin network, because it is using the Bitcoin network to do all of the above.
Paying for assets with BTC is a major luxury found exclusively on Counterparty for the time being. It makes obtaining XCP or other counterparty assets extremely safe, very very easy seeing as most people reading this own some BTC or could get it easier than any other cryptocurrency, and best of all legally sound! Nevermind having no counterparty risk, there’s no FBAR risk! lol! since you’re not using a custodial service to do any of this, there’s no onerous reporting requirements involved.
If sidechains prove safe and secure, Counterparty has every incentive to move to one because they could lift imposed limits on declarative data in the Bitcoin main chain by moving to a sidechain they have full control over, and they could also probably speed up network confirmations substantially. They could accomplish all of the above without losing any balances, and the network would continue functioning as normal; the problem is sidechains are completely unproven right now. No one knows if they are safe enough to use due to a variety of outstanding security issues many of them having to do with mining. Sidechains are rocket scientistry, whereas just putting Counterparty on Bitcoins works right now, and it works well. Counterparty is a sound way of facilitating multiparty trades and advanced financial contracts without involving intermediaries through declarative Bitcoin transactions. Recognize!